America's Credit Downgraded: What You Need to Know

So, this happened.

Rumors were swirling all day, and then it finally hit: Standard & Poor's downgraded the nation's credit rating this evening, the first time the U.S. Treasury has lost its pristine AAA rating since ratings began nearly a century ago.

S&P now rates the United States at AA+. The rating agency didn't beat around the bush when describing why it made the cuts:

The political brinksmanship of recent months highlights what we see as America's governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed. The statutory debt ceiling and the threat of default have become political bargaining chips in the debate over fiscal policy. Despite this year's wide-ranging debate, in our view, the differences between political parties have proven to be extraordinarily difficult to bridge, and, as we see it, the resulting agreement fell well short of the comprehensive fiscal consolidation program that some proponents had envisaged until quite recently. Republicans and Democrats have only been able to agree to relatively modest savings on discretionary spending while delegating to the Select Committee decisions on more comprehensive measures. It appears that for now, new revenues have dropped down on the menu of policy options. In addition, the plan envisions only minor policy changes on Medicare and little change in other entitlements, the containment of which we and most other independent observers regard as key to long-term fiscal sustainability.

No big surprises here. The rating agencies have had the nation's credit rating on notice for months, warning Washington that without getting its fiscal house in order, and keeping political cage matches away from serious economic issues, a downgrade loomed. The debt-ceiling deal struck earlier this week failed on the former, and made the latter go prime-time. So here we are.

What's it mean for markets? No one can say for sure. Some sort of visceral fear-laden response on Monday seems likely. If there is a big selloff, it's not just about investors panicking. It's about investors expecting that other investors will be panicking and trying to preempt them. Do yourself a favor and don't pay much attention to any dramatic market reactions next week. The traders and computer algorithms that influence daily market moves almost certainly have different goals from the average Motley Fool investor.

Longer-term, the downgrade could mean a jump in interest rates. That could slow economic growth and literally add trillions of dollars to the national debt in higher borrowing costs.

This, though, is debatable. On average, AA-rated countries pay about 0.7% more to borrow than AAA-rated ones. But there are exceptions. Japan's interest rates actually fell after it was downgraded in 2001. The United States issues (or used to issue) about 60% of the world's AAA-rated debt. Investors who want high-quality debt in large amounts don't have many choices besides Treasuries. In that case, the downgrade might have little impact. It might just mean that AA becomes the new AAA. This is the argument that those who think the downgrade will be a nonissue use, and they very well may be right.

How did we get here? Federal debt exploded over the past few years as the recession smashed the economy:

Sources: Federal Reserve, author's calculations.

Interestingly, though, interest rates have plunged so deeply that even as debt accumulated, total interest paid on that debt -- what I've argued is the most important figure when looking at the national debt -- has dropped to nearly a historic low:

Source: Office of Management and Budget.

And as S&P hints at, the rise in debt in recent years has been caused almost as much by a drop in tax revenue as it has a jump in spending: